The Shareholder Wealth Implications of Corporate Lawsuits

By Bhagat, Sanjai; Bizjak, John et al. | Financial Management, Winter 1998 | Go to article overview

The Shareholder Wealth Implications of Corporate Lawsuits

Bhagat, Sanjai, Bizjak, John, Coles, Jeffrey L., Financial Management

The modern corporation interacts with the external environment in many ways. Examples of external interfaces include: suppliers of raw materials, labor, and intermediate products in input markets; suppliers of funds in capital markets; customers in final product markets; and executives in managerial labor markets. Another important external connection is to other firms, private parties that are not corporations, and governments, all by way of the system of legal rules and institutions. In this regard, it is widely perceived that litigation is playing an increasingly important role in society. In the business community, in particular, managers claim to face increasing use of the legal system in running the firm and have expressed concern over the risks and costs associated with legal disputes.

Involvement of business in litigation appears to be borne out in the data. Out of more than four million federal lawsuits filed between 1971 and 1991, nearly 2.5 million involved at least one business entity (Wall Street Journal, December 3, 1993, B 1). Furthermore, a recent Rand study (Dungworth and Pace, 1990) of Fortune 1000 companies found that contract disputes between firms constituted the largest single category of federal civil suits. On the basis of their survey of corporate legal department budgets, Economic Analysis Group, Ltd., Craig Consulting Co., and Endispute, Inc. estimate that salaries to in-house lawyers and fees to outside counsel for the 1,000 largest public companies hit $20 billion in 1991.(1) Furthermore, large liability or settlement payments can dwarf such direct legal costs. For example, some mass torts, such as the breast-implant cases against Dow Corning and the Dalkon Shield cases against A.H. Robins, have threatened the very existence of the defendant firms.

On the other hand, it is possible that these estimates of legal risks and costs to business and society are overstated, reflecting political agendas or resulting from overreaction to media coverage of a few spectacular cases. One can point to the fact that many of the enormous damage awards emphasized by the media are later overturned on appeal or significantly reduced in a settlement.(2) In addition, not all types of litigation have been on the rise. The number of federal civil suits involving corporations has declined by 12% since 1986 (Dungworth and Pace, 1990).

Much of the reason for disagreement about the risks and costs to both firms and society of legal disputes arises from a lack of empirical evidence on the costs and benefits to parties that become involved in a lawsuit. Such information would be required to address any of the really large questions, such as whether actual or potential lawsuits affect shareholder wealth enough to deter management from taking inappropriate actions, whether frivolous suits and excessive judgements hamper American firms as they compete against their foreign counterparts, and whether our legal system prevents products from being developed and marketed. While it would be ideal to have reliable data to address these and similar issues, at a much more basic level very little is known about corporate litigation as an economic phenomenon.(3) Even so rudimentary a statistic as the total number of lawsuits filed each year against the major exchange-listed firms is unknown.

The purpose of this paper is to provide basic information on the topography of the legal landscape in which corporations operate. We collect and analyze a large sample of lawsuits in which at least one side, plaintiff or defendant, is a corporation. In particular, we provide evidence on the relative frequency of the legal issues involved and the type of opponent, as well as on the incidence of suits through time. To estimate the implications of litigation for shareholder wealth, we examine the abnormal stock market reaction to filing and settlement announcements. Market returns, in the absence of substantial market frictions, will reflect rational expectations as to the prospects of the firm in the legal dispute (Coles, 1992). …

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